Money In The Middle

Retail owners and developers are discovering that the once exclusive mezzanine market is now an open playing field.

No longer are mezzanine loans exclusive to large borrowers that can absorb hefty transaction costs. An increasingly crowded mezzanine market is forcing lenders to lower rates, slash transaction costs and streamline processes, which is making the loans more accessible to a wider range of borrowers.

And borrowers are taking full advantage of those changes. Although mezzanine activity can be difficult to quantify, U.S. lenders reported issuing 19 billion dollar's worth of seconds, mezzanine and preferred equity in 2005, which accounted for 5 percent of the total lending origination volume, according to the Mortgage Bankers Association. That volume represented a 200 percent increase compared to the $6.3 billion originated in 2004. (MBA has not released 2006 figures yet.)

“We had a record year last year. The market has been robust, and it looks like that activity will continue,” says Marty Lanigan, president and CEO of Mezz Cap. The Short Hills, N.J.-based firm financed about $110 million in mezzanine transactions in 2006. That volume is up about 46 percent compared to the approximately $75 million in transactions the firm completed in 2005, and Mezz Cap is expecting another strong year in 2007 with an estimated $125 million to $150 million in financing.

That explosive growth is due to a variety of factors. Chief among them is the fact that mezzanine capital is not only plentiful, but it's cheaper and easier for borrowers to access. Generally, the rate on mezzanine loans ranges between 11 percent and 12.75 percent, which is down about 200 basis points in the past few years.

In addition, intense competition has forced lenders to tap a broader market. Lenders that once targeted deals in excess of $50 million are now pursuing deals as low as $100,000. Competition has intensified as more lenders have pushed into the mezzanine sector in search of higher returns. At the same time, mezzanine's slice of the capital stack has shrunk as senior lenders have become more aggressive in covering a borrower's needs — up to 80 percent or 85 percent of the total loan-to-value ratio. That leaves a smaller — and riskier — sliver for mezzanine lenders to play with.

Simplifying the process

Traditionally, the fees associated with mezzanine loans have made smaller loans cost-prohibitive. But many lenders are finding a way to offer mezzanine loans on smaller deals without the fees by “piggybacking” the mezzanine layer on top of the first mortgage. The mezzanine lender uses the same due diligence, underwriting and legal work that was already conducted, so there is no duplication of processes or fees.

“A lot of mezzanine lenders don't want to write small balance loans. We do them in cases where we also do the first mortgage, so there is no additional cost,” says Chris Tokarski, managing director of commercial real estate finance at Countrywide Commercial in Calabasas, Calif. For example, Countrywide recently provided a $2 million mezzanine loan on a 144,000-square-foot shopping center in Austin, Texas, that is anchored by HEB. The mezzanine financing was layered on top of a $13.8 million first mortgage. “The mezz took total leverage to 92 percent for 180 days to allow the borrower to syndicate the equity,” Tokarski says. In fact, through its new Advantage Plus program, Countrywide provides an additional 10 percent of financing on top of the first mortgage with mezzanine loans as low as $100,000.

Mezz Cap uses a similar piggybacking strategy in working with its myriad of strategic lending partners across the United States including firms such as CIBC, Goldman Sachs, JP Morgan and Wachovia. “We only lend with our strategic lending partners, so we have already pre-established documentation through them,” Lanigan says. “Where they are willing to commit their capital, we're willing to follow.”

The evolution in the mezzanine market has opened up new opportunities for small and mid-sized retail owners and developers. Another trend is that mezzanine capital is available on a wider geographic scope. “Historically, you have seen lenders willing to lend in maybe 12 major cities around the country,” Lanigan says. Mezz lenders were not active in secondary markets such as Indianapolis and Jacksonville, Fla.

However, the market has shifted, in large part because conduits forged into these secondary markets. Conduits were able to go in and understand the smaller markets. The conduits were able to establish a comfort level by evaluating local real estate and economic factors and specific credit risks, and mezz lenders have since followed suit, Lanigan says. Mezz Cap, for example, has completed transactions in 42 states, and is active in a number of secondary markets ranging from Spokane, Wash., to Reno, Nev.

Value-added resource

Mezzanine financing appeals to owners and developers across property types. The demand is driven largely by opportunistic owners and developers who are seeking to add value through new construction or repositioning.

Properties with stable cash flow that have value-add potential or upside in cash flow are ideal for mezzanine financing. Such value-added opportunities can come from below-market rents, absorption or scheduled rent bumps during the loan term that will improve cash flow and create an exit for the higher leverage. “What makes retail ideally suited for mezzanine debt is that the upside can be clearly identified based on lease steps and how the property compares to the market,” Tokarski says. “Tenants don't like to move in retail properties, so if you can determine that tenants are doing well, your cash flows are generally pretty stable.”

“Developers have certainly become more aware of mezzanine finance. It's not seen as being as mystical or complex as it once was,” says Ari Altman, a vice president at Huntington Capital Markets in Columbus, Ohio. Huntington recently provided $7.5 million in mezzanine financing for the Streets of Indian Lake in Hendersonville, Tenn. Columbus, Ohio-based Continental Real Estate is developing the 405,000-square-foot lifestyle center scheduled to open in March 2008. “Developers are anxious to line up that financing, and they don't always have their ducks in a row,” Altman says. “In the case of the Streets of Indian Lake, that project is under construction, and it is leasing up nicely as we thought it would.” Continental recently announced signing major tenants such as Barnes & Noble, Regal Cinema, Ann Taylor and Qdoba Mexican Grill.

Hot commodity

Mezzanine lending is popular with borrowers, lenders and investors alike. Lenders and investors like mezzanine finance because it offers higher returns in a market where real estate yields are continuing to get squeezed. Mezzanine loans are priced at 11 percent to 12.75 percent compared to about 6 percent for a traditional first mortgage. “The market is in such a frenzy looking for yield that there are more and more options for the borrower,” says Dan Walsh, managing director of the Private Equity Group at Cleveland-based KeyBank Real Estate Capital.

Mezzanine financing represents a steadily growing part of the private equity group at KeyBank. About 70 percent of the current lending portfolio in the private equity group is devoted to mezzanine loans with $200 million in new production during 2006. Part of that growth is due to the fact that KeyBank partnered with Hartford Insurance to create a new mezzanine fund. “The reason there is so much liquidity in the real estate market today is because there are no better alternatives outside of real estate,” Walsh says.

Retail property owners and developers like mezzanine financing because it allows them to put less equity into a project. “Developers of all sizes are looking to mezzanine to supplement money that once had to come out of their pocket,” Altman says. Although mezzanine financing is more expensive than a first mortgage, it is typically less expensive than a borrower's own equity. And unlike bringing in a venture partner, the borrower retains control of the asset.

Mezzanine lending can be key for up-and-coming retail developers that don't have deep pockets or an established track record. Case in point is Columbus, Ohio-based Stanbery Development. Founded in 2000, the lifestyle center developer turned to mezzanine financing to fill the equity on three of its early projects, including the Shoppes at Susquehanna in Harrisburg, Pa., which opened in October 2004.

“Mezzanine money is relatively expensive, but what attracted us to it was that when it came time to arrange permanent financing we could effectively buy out the mezzanine component and still retain 100 percent of the ownership,” says Matt McClimon, CFO of Stanbery Development.

Greater liquidity

Growing investor appetite for the higher yielding mezzanine loans is further boosting activity. “There is a lot more mezzanine activity in large part because there is an awful lot of capital looking for a home in real estate,” says Susan Merrick, managing director of commercial mortgage-backed securities for New York City-based Fitch Ratings. The outstanding performance of mezzanine loans, especially on the default and loss side, coupled with the increased demand for higher yielding real estate paper is fueling mezzanine activity, she adds.

Approximately 32 percent of the loans in Fitch-rated CMBS issuance contain a mezzanine tranche. That volume is nearly four times the 8.4 percent mezzanine level in June 2001. In fact, Merrick says she is surprised the volume of loans with a mezzanine component is not higher considering the fact that mezzanine loans are more liquid today than they were just 18 months ago. “We're seeing a lot more mezzanine debt, because it can be securitized,” she says.

Mezzanine loans are finding an exit strategy in the real estate collateralized debt obligations (CDO) market — which are similar to CMBS, but can include a broader range of debt. Mezzanine loans began appearing in the commercial CDO market in 2005. The industry figured out how to rate mezzanine transactions in a way that is consistent with CMBS transactions, which allows them to be a much more popular vehicle for CDO.

The CDO market gives lenders the ability to turn around and obtain leverage or finance a mezzanine loan. “The CDO market is what's really driving the mezzanine market. As long as that remains healthy, mezzanine will continue to have a lot of participants,” says Countrywide's Tokarski.

So far the CDO market remains incredibly robust. The commercial real estate CDO market generated $31 billion in 2006, and the industry is expected to post a record $50 billion in 2007, according to Merrick. “I think people are capitalizing on mezzanine opportunities. Yes, they can get more yield. But it also opens up a huge array of new assets they can look to include in securitizations,” Merrick says.

Momentum continues

Although borrowers are certainly taking advantage of the plentiful supply of mezzanine capital, some industry observers are concerned about rising risks associated with loan defaults. In theory, more aggressive lending could prompt a rise in loan defaults, which would in turn curb financing activity. “Mezzanine lenders make more aggressive — proposing to lend more money, which can constrict coverage,” Altman says. “We feel that we have to be disciplined in that. So we haven't won every deal.”

Another downside of the heated competition is that some lenders that are making an aggressive quote early on are having a hard time sticking to that commitment once they get further into the transaction. Once mezzanine lenders start walking away from deals, or changing the original terms of a deal, it undermines borrower confidence in the industry as a whole, Lanigan notes.

Despite those concerns, lenders remain optimistic that activity will remain brisk throughout 2007. “We have come out of the chute with great production numbers for the first two months, and so far it looks like that is going to continue.”